Last year’s appreciation of the Canadian dollar put a major squeeze on manufacturers’ profits. But with exports now on a solid recovery track, profit margins are widening in most sectors.
It is worth reviewing the theory of exchange rate effects. In economics textbooks, the rise in the Canadian dollar boosts the price of Canada’s exports, causing foreigners to buy less of them, and profitability quite naturally is eroded. The problem with this analysis is its assumption that companies price their export sales in Canadian dollars, which is not that common. A majority of exporters price their wares in U.S. dollars, which means that a rise in the Canadian dollar has no impact on the foreign buyer at all – its effects are mostly internal to the Canadian company.
What this means is that exports can actually rise after the dollar rises (as we are now seeing), but each sale priced in U.S. dollars yields fewer Canadian dollars (less profit) than before. The impact on manufacturers was widespread, but varied by sector. For example, the wood and paper sector saw a profit margin of seven per cent in 2001 and five per cent in 2002, but it fell to two per cent in the second quarter of 2003.
The good news is that profit margins have begun to recover in most manufacturing sectors. Margins in the wood and paper sector have recovered to 5.8 per cent in 2004 Q1, the latest data. Similarly, producers of alcoholic beverages and tobacco have seen margins rise from 20.6 per cent to 25.8 per cent. Margins bottomed in 2003 Q3 for most others, with big recoveries in food and beverages (4.9 per cent to 5.9 per cent), printing (5.1 per cent to 7.4 per cent), primary metals (3.2 per cent to 5.1 per cent), electronics (-0.2 per cent to +3.2 per cent), motor vehicles (-1 per cent to +2 per cent) and motor vehicle parts (5.8 per cent to 7.7 per cent).
For some other sectors, the stress continued into the fourth quarter, but margins have recently come back more or less into line with historical performance. Examples include petroleum and coal; chemicals, plastics and rubber; non-metallic minerals; and fabricated metals. There has also been a modest profit recovery in furniture, but margins remain low at five per cent. And there has been no meaningful profit recovery in clothing, textiles and leather (3.4 per cent) or electrical components and appliances (2.7 per cent), where international competition is probably the toughest. Profitability is being restored in various ways. Investment in new equipment is booming – imports of these items are up 20 per cent over last year. But the most important effect has been through increased production. Companies can boost their efficiency and productivity simply by increasing production, especially if they do so without adding staff – and employment in manufacturing has barely risen in the past year, which means that productivity has gone up significantly.
However, the capacity utilization data show that operating levels are still quite low in the textiles, clothing, leather, electrical appliances and furniture sectors, where profit stresses are still the greatest.
The bottom line? Profit margins are expanding again, almost across the board, largely as a result of the emerging export recovery. With the world economy expected to continue to grow into 2005, the profit recovery should continue, and hopefully broaden into those sectors still under stress.
(Stephen S. Poloz is senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
